Beware Of The Walking Dead In Your Portfolio

Pop culture often reflects the more insidious trends at work beneath the surface of society. Take America's current fascination with zombie shows like The Walking Dead. I manage a large portfolio of corporate bonds, but when I peer into my Bloomberg Terminal, I am confronted by the walking dead daily. I am referring to zombie credits--seemingly healthy bonds issued by institutions with dubious economic net worth and unsustainable business models.

The animator of these corporate corpses is none other than the Federal Reserve and its quantitative easing program. No industry outside banking has benefited more from the Fed's largesse, and the yield hunger of investors, than retailers.

Screams and moans. Cries of despair. The smell of burning cash. Voracious appetites for capital that can never be satiated. Those should be the sounds coming from the boardrooms of two legacy retailers, J.C. Penney and
Sears Holdings. Yet these zombies somehow continue to anchor shopping malls.

Indeed, both retailers have tapped capital markets post-2008 despite materially deteriorating financials. It's a popular trend among legacy retailers--layer on debt to live another day.

Like zombies, these retailers also have rapacious cravings: for cash.
Moody's currently estimates that Sears will burn through $1 billion this year alone. J.C. Penney managed to post nine consecutive unprofitable quarters prior to eking out a small gain in the fourth quarter of 2013. Sears is not far behind, with seven consecutive unprofitable quarters. There are other zombie retailers. RadioShack,
Best Buy and Barnes & Noble have all closed stores.

Don't worry, they're simply too flush to fail. They represent unintended consequences of our central bank's QE program, which has essentially allowed the U.S. to defer, if not entirely skip, a normal default cycle in which troubled companies are culled from the marketplace.

In and of themselves Sears and J.C. Penney, with a combined $10 billion or so in debt, don't make up a significant part of any major corporate bond index. Still, they operate sizable businesses, with more than 350,000 employees, and have a significant ripple effect on the economy. Shopping mall REITs CBL & Associates Properties and Simon Properties are landlords to dozens of their stores.

Both J.C. Penney and Sears carry debt ratings from Moody's of around Caa, which is pretty junky. But the spigot is still open for them--five-year loan obligations trade at a respectable 6.625% yield.

I have nothing against either J.C. Penney or Sears. To this day a whiff of caramel corn constitutes a Proustian moment that takes me right back to the Sears of my youth in Orange County, Calif. But both of these retailers are doomed. If they have any value today, it's in their real estate. Sears has regularly engaged in asset liquidations, and the current investment thesis for J.C. Penney's senior bonds depends largely on extracting value from its real estate, not from any operating turnaround.

The Internet has rewritten the logistics of retail and the habits of consumers. So betting on mall real estate is a risky game. Indeed, Chicago's ShopperTrak reported that U.S. store visits fell 21% in the week prior to Christmas 2013.

Most individuals have exposure to fixed income through ETFs or bond index funds. With these the most indebted issuers typically make up the largest slice. That's troubling given that some of the sickest businesses have used QE as an opportunity to pile on debt.

For corporate bond investors this means active management is probably the best course. Retailers are the most obvious zombie creditors roaming the landscape, but others are hidden in bond portfolios. Quantitative easing is ending. This could stop "walkers" dead in their tracks. Yield-thirsty investors, take note.